Exchange Traded Options.

Transcription

1 Exchange Traded Options. Product Disclosure Statement Part 1 Incorporating Part 2: Schedule Of Fees INDEX TO PART 1 PURPOSE OF A PDS 2 PDS IN TWO PARTS 2 WHAT PRODUCTS DOES THIS PDS COVER? 2 INTRODUCTION 2 Education Booklets 3 ABOUT E TRADE 3 Trading Exchange Traded Options through E TRADE Australia 3 How do your orders get executed? 3 WHAT ARE EXCHANGE TRADED OPTION CONTRACTS? 3 WHAT ARE LEPOs? 4 Differences between LEPOs and standard Exchange Traded Options 4 Deliverable or cash settled 4 Standardised Contracts 4 Premium 5 Factors Affecting Option Premium 5 Time value 5 Time to expiry 5 Volatility 5 Interest Rates 5 Dividends 5 No dividends or Entitlements 6 Opening an option position 6 Closing out of option contracts 6 Expiry 6 Exercise 6 Automatic exercise 6 Settlement 7 SIGNIFICANT BENEFITS OF EXCHANGE TRADED OPTIONS 7 SIGNIFICANT BENEFITS OF LEPOs 8 SIGNIFICANT RISKS EXPLAINED 9 SIGNIFICANT RISKS OF LEPOS EXPLAINED 9 COSTS AND AMOUNTS PAYABLE ASSOCIATED WITH TRADING EXCHANGE TRADED OPTIONS 10 Costs 10 Amounts payable 10 Margins 10 OTHER SIGNIFICANT CHARACTERISTICS OF EXCHANGE TRADED OPTION CONTRACTS 10 Trading and clearing options 10 Client trust accounts and collateral 10 National Guarantee Fund 11 DISPUTE RESOLUTION SYSTEM 11 SIGNIFICANT TAXATION IMPLICATIONS 11 Revenue Account 11 Writer of the Option 11 Taker of the Option 12 Capital Account 12 Writer of the Option 12 Taker of the Option 12 Goods and Services Tax 12 Issued by: ETRADE AUSTRALIA SECURITIES LIMITED Australian Financial Services Licence No ABN: Date of Issue: 10 April 2007

2 The information is this Product Disclosure Statement (PDS) does not take into account your personal objectives, financial situation and needs. Before trading in the products referred to in this PDS you should read this PDS and be satisfied that any trading you undertake in relation to those products is appropriate in view of your objectives, financial situation and needs. We recommend that you consult your financial adviser or obtain other independent advice before trading in exchange traded options. PURPOSE OF A PDS This PDS has been prepared by ETRADE Australia Securities Limited ( E TRADE Australia or E TRADE ), the issuer of the exchange traded options. This PDS is designed to assist you in deciding whether the products covered in this PDS are appropriate for your needs. This PDS has been prepared to assist you in comparing it with others you may be considering. The PDS is an important document and we recommend you contact us should you have any questions arising from the PDS prior to entering into any transactions with E TRADE. When we use terms we, us or our in this PDS, the reference is to E TRADE. If you have any questions in relation to this PDS, please do not hesitate to contact us on or write to us at: ETRADE Australia Securities Ltd. Reply Paid 1346 ROYAL EXCHANGE NSW 1225 PDS IN TWO PARTS This Product Disclosure Statement (PDS) is in two parts. The first Part contains all information other than the Schedule of Fees. The information in this PDS does not take into account your personal objectives, financial situation and needs. Before trading in this product you should be satisfied that such trading is suitable for you in view of those objectives, and your financial situation and needs, and we recommend that you consult your investment advisor or obtain other external advice. WHAT PRODUCTS DOES THIS PDS COVER? This is a Product Disclosure Statement for exchange traded options traded on ASX Limited Group (ASX) and settled and cleared by Australian Clearing House Pty Ltd (the Clearing House). It deals with exchange traded equity options, index options ( exchange traded options ) and Low Exercise Price Options (LEPOs). Exchange traded equity options are options over quoted shares (or other securities) of a range of different companies listed on ASX. Exchange traded index options are options over an index such as the S&P /ASX 200 Index or the S&P /ASX 200 Property Trust Index. LEPOs are call options with an exercise price of one cent. A list of companies and indices over which exchange traded options are traded can be found on the ASX website INTRODUCTION Exchange traded options are a versatile financial product which can allow investors to: hedge against fluctuations in their underlying share portfolio increase the income earned from their portfolio to profit from speculation Their flexibility stems from the ability to both buy and short sell an option contract and undertake multiple positions targeting specific movements in the overall market and individual equities. The use of Exchange Traded Options within an investor s overall investment strategy can provide great flexibility to take advantage of rising, falling and sideways markets. However, both the purchase and sale of exchange traded options involves risks which are discussed at length on pages 9 to 10. Specific concepts which should be practically understood before engaging in an options strategy are: The effect time has on any one position/strategy; How volatility changes, both up and down, may change your pay-off diagram for a position; How to calculate margins and worst-case scenarios for any position; The likelihood of early exercise and the most probable timing of such an event; The effect of dividends and capital reconstructions on an options position; Liquidity of an options series, the role of market makers, and the effect this may have on your ability to exit a position. When buying an ETO the initial outlay of capital may be small relative to the total contract value so that transactions are leveraged or geared. Transactions should only be entered into by investors who understand the nature and extent of their rights, obligations and risks associated with trading exchange traded options. When selling an ETO the initial income may seem attractive but the downside may be unlimited. Risk minimisation strategies should be employed to mitigate losses when a position does not move in a favourable manner. Whilst this PDS provides product information including information about the risks, characteristics and benefits of exchange traded options, investors should inform themselves and if necessary obtain advice about the specific risks, characteristics and benefits of the exchange traded option they intend to trade and relevant ASX rules. 2

3 Educational booklets: Exchange traded options have been traded in Australia since 1976 on the ASX. Over this time, ASX has prepared a number of educational booklets relating to exchange traded options which are available to you via their website, In addition to reading this PDS, investors are advised that the PDS cross references certain of the ASX booklets. The ASX booklets that relate to options include Understanding Options Trading, Margins, Understanding Option Strategies which are available free on the ASX website These booklets provide useful information regarding options traded on the ASX, including option features, advantages of options, risks associated with options, option adjustments, option pricing, margins, taxation and option contract specifications. One of the ASX booklets entitled Understanding Options Trading is a booklet which we must give you in accordance with the ASX operating rules when you sign our client agreement to trade exchange traded options. This booklet is also available on line at If you cannot access the ASX booklets via the ASX website, please contact us immediately and we will arrange to forward copies of the booklets to you at no charge. If you have any questions on any aspect of the booklets you should consult E TRADE before making any investment decisions. ABOUT E TRADE E TRADE has been a leading financial services provider since E TRADE: ACN ; Australian Financial Services Licence Number: Address: Level 7, 10 Bridge Street, Sydney NSW 2000 Postal address: Reply Paid 1346, Royal exchange NSW 1224 Phone: Fax: service@etrade.com.au Website: Trading Exchange Traded Options through E TRADE Before we will accept orders to trade ETO s on your behalf, you will need to have entered into a Derivatives Client Agreement with E TRADE. How do your orders get executed? Once it approves your orders, and subject to any time delay instructions given by you or your authorised agents, E TRADE will place them directly into the ETO market. Unlike online orders it receives from clients wishing to deal in equity products, E TRADE does not currently use Automated Order Processing to place ETO orders into the market, although it may do so in the near future. When it does begin using Automated Order Processing to place ETO orders into the market, E TRADE reserves the right to reject any ETO order received, or refer any such order received to one of E TRADE s CLICK Operators, for review and determination of which orders will be placed into the ETO market. E TRADE offers its clients the ability to place orders in ETO s either by phone or via the internet. (Orders placed via phone may incur an additional charge refer Part 2: Schedule of Fees.) WHAT ARE EXCHANGE TRADED OPTION CONTRACTS? Exchange traded options may be American or European style exercise. Most ASX options are American style which means they are tradeable and can be exercised at any time prior to the expiry day. European options which includes index options and LEPO s, can only be exercised on the expiry day and not before. An exchange traded option is a contract between two parties which gives the buyer (the taker) the right, but not the obligation, to buy or sell the shares underlying the option at a specified price (exercise price) on, or before a predetermined date. To acquire this right, the taker pays a premium to the writer (seller) of the contract. When considering options over an index or LEPO, the same concepts generally apply. The premium is not a standardised feature of the exchange traded option contract and is established between the taker and writer at the time of the trade. See the discussion on premium for more information. Exchange traded option sellers are referred to as writers because they underwrite (or willingly accept) the obligation to deliver or accept the shares covered by an option. Similarly, buyers are referred to as takers of an exchange traded option as they take up the right to buy or sell a parcel of shares. Every exchange traded option contract has both a taker and a writer. There are two types of exchange traded options, namely call options and put options. All option positions consist of one or more of either a bought call, a sold call, a bought put, or a sold put. A long (or bought) option position is created by the purchase of a call or put. A short (or sold) position is created by the sale of a call or put. By combining two or more of these basic positions, an investor can create a trading strategy that meets a range of investment objectives, including the protection of an existing portfolio of shares. For more information on possible trading strategies we refer you to the ASX Booklet entitled Understanding Options Strategies available on the ASX website at Call options give the taker the right, but not the obligation, to buy a standard quantity of underlying shares at a predetermined price on or before a predetermined date. If the taker exercises their right to buy, the seller (writer) is required to sell a standard quantity of shares at the predetermined exercise price. 3

4 Put options give the taker the right, but not the obligation to sell a standard quantity of underlying shares at a predetermined price on or before a predetermined date. If the taker exercises their right to buy, the seller (writer) is required to buy a standard quantity of shares at the predetermined exercise price. The premium is the price of the option agreed to by the buyer and seller through the market. The taker will always pay the writer a price (called the premium) to enter into the option contract. The writer receives and keeps the premium but has the obligation to buy from or deliver to the taker the underlying shares at the exercise price if the taker exercises the option. WHAT ARE LEPOs? LEPOs are European style option contracts with an exercise price of one cent. LEPOs can only be exercised on the last trading day before they expire. When you buy a share LEPO, you obtain the right to buy an agreed number of shares (1,000 per contract) at a specified future date, in return for the payment of the exercise price (1 cent) and a premium. Index LEPOs are also available. The seller of a LEPO undertakes to sell the underlying securities at expiry in return for the exercise price and the premium amount at which the LEPO originally traded. As with other options, the seller of a call option is only required to deliver the underlying shares if the buyer exercises the option. LEPOs allow investors to profit from movements in the underlying security on a one-for-one basis. Buying a LEPO is similar to a forward purchase of shares, while selling a LEPO is similar to a forward sale of shares. Because of their low exercise price, LEPOs trade for large premiums. The high premium exposure carries a risk similar to that of owning the securities outright or, for writers, short selling securities. Although the exposure with LEPOs is similar to owning the shares you don t receive dividends directly. The value of the dividend is factored into the LEPO price. An important feature of LEPOs is that both the taker and the writer are margined. When you buy a LEPO, you do not pay the full amount of the premium upfront. Instead, you pay or receive margins during the life of the LEPO and pay or receive the balance of the premium if and when you exercise the LEPO. Differences between LEPOs and standard Exchange Traded Options LEPOs are different from standard exchange traded options because LEPOs: Are only available as call options. Are European style options, meaning they are exercisable on the last trading day before they expire, while standard exchange traded options are American style options exercisable at any time before expiry. Have a very low exercise price and a much higher premium close to the initial value of the underlying shares the subject of the LEPO. Have only one exercise price per expiry month, unlike other options, which offer a range of exercise prices. Do not require an amount equal to the full premium to be paid on purchase. Instead the buyer pays a margin, which represents a small percentage of the value of the underlying shares. Involve ongoing margin payments from both seller and buyer of the option. Deliverable or cash settled Exchange traded options are either deliverable or cash settled. Most exchange traded equity options are deliverable, that is with physical delivery of the underlying security, whilst index options are cash settled. Cash settlement occurs in accordance with the rules of the Clearing House against the Opening Index Price Calculation (OPIC) as calculated on the expiry date. Standardised Contracts Exchange traded options are created by the exchange on which the underlying equity or index is listed. E TRADE trades exchange traded options in relation to companies and indices listed on the ASX. The ASX website provides a list of companies and indices over which exchange traded options are traded, these can be found at ASX determines the key contract specifications for each series of exchange traded options listed, including: (a) the underlying security or underlying index; (b) the contract size where 1 option contract on ASX usually represents 1000 underlying shares; (c) the exercise price (or strike price) The exercise price (or strike price) is the specified price at which the taker (buyer) of an equity option can buy or sell the underlying shares. The ASX sets the range of exercise prices at specific intervals according to the value of the underlying shares. LEPOs have an exercise price of one cent. It is important to note that the exercise price of an equity option may change during the life of an option if the underlying share is subject to a bonus or rights issue or other form of capital reconstruction. The number of underlying shares may also be subject to an adjustment; and (d) the expiry date exchange traded options have a limited pre-determined life span and generally follow one of three cycles, namely: (i) January/April/July/October (ii) February/May/August/November (iii) March/June/September/December. The ASX may in accordance with its operating rules make an adjustment to any of the above specifications if the listed entity over which the option relates makes a pro-rata change to its 4

5 ordinary share capital structure (eg. Bonus issues or special dividends are declared). If ASX does make an adjustment it will endeavour to preserve the open positions of takers and writers at the time of the adjustment as best as possible. ASX has issued an Explanatory Guide for Option Adjustments which can be found at ExplanatoryNoteforOptionAdjustments.pdf which provides further information regarding ASX option adjustments. Full details of all exchange traded options listed on ASX and expiry date information can be found on the ASX website at or alternatively through information vendors or newspapers. A list of current option codes and delayed price information is available on the ASX website at Details of the previous day s trading are published in summary form in the Australian Financial Review and more comprehensively in The Australian. If you cannot access the above information, please contact us and we will arrange to provide you with the information. Details of contract specifications for exchange traded options are published by the ASX on their website at specs.htm The contract specifications detail the key standardized features of exchange traded options and index options traded on ASX. Premium The premium (price of the option) is not set by the ASX. It is negotiated between the buyer and seller of the exchange traded option through the market. The premium for an equity option is quoted on a cents per share basis so the dollar value payment is calculated by multiplying the premium amount by 1,000 (the number of underlying shares). For example, if you buy a call option with a premium quoted at 25c per share, the total premium will is $ (being $0.25 x 1,000). The premium for an index option is calculated by multiplying the premium by the index multiplier. For example, a premium of 30 points, with an index multiplier of $10, represents a total premium cost of $300 per contract. Factors Affecting Option Premium Option premium will fluctuate during the option s life depending on a range of factors including the exercise price, the price of the underlying securities or the level of the index, the volatility of the underlying securities or the underlying index, the time remaining to expiry date, interest rates, dividends and general risks applicable to markets. For exchange traded options, market expectations and ultimately, the pressures of supply and demand determine the value of options Time Value Time value represents the amount an investor is prepared to pay for the possibility that the market might move in their favour during the life of the option. The amount of time value will depend on whether the option is in-the-money, at-the-money or out-of-the-money. At any given time, the at-the-money option will have the greatest time value. The further in- or out-of-the-money the option is, the less time value it will have. A call option is said to be in-the-money where the exercise price is less than the share price. A call option is said to be at-the-money where the exercise price equals the share price. A call option is said to be out-of-the-money where the exercise price is greater than the share price. A put option is said to be in-the-money where the exercise price is greater than the share price. A put option is said to be at-the-money where the exercise price equals the share price. A put option is said to be out-of-the-money where the exercise price is less than the share price. An option s time value is affected by the following factors: Time to expiry - the longer the time to expiry, the greater the time value of the option. Time value declines as the expiry of the option draws closer. This erosion of time value is called time decay. It is not constant, but increases rapidly towards expiry. Volatility - in general, the greater the volatility of the underlying asset, the greater the time value will be. This is due to the fact that the writer is exposed to a greater probability of incurring a loss, and will require higher premium income to compensate for the increased risk. Interest rates - an increase in interest rates will lead to higher call option premiums and lower put option premiums, all else being equal. This reflects the cost of funding the underlying shares. The taker of a call option can defer paying for the shares until the option s expiry date, and invest the funds elsewhere during this period. As interest rates rise, more interest can be earned on the funds, so the call option is worth more to the option taker. The effect of an interest rate rise is the opposite for put options, as the taker is deferring the receipt, rather than the expenditure of funds. Dividends - if a dividend is payable during the life of an option, the premium of a call option will be lower, and the premium of a put option higher, than if no dividend was payable. This is because shares tend to fall in value on going ex-dividend, all else being equal. Anything that leads to lower share prices will make call options less valuable, and put options more valuable.

6 In practice, option pricing is complex and involves the use of mathematical formulae to calculate the intrinsic value and time value of options. For more information on option pricing, you should refer to the section entitled Option pricing fundamentals in the ASX Booklet Understanding Option Trading. ASX also provides a pricing calculator on the ASX website, options/booklets.htm You can obtain current price information on ETO s via our normal website, or, if you are an active trader, via either E TRADE pro or Power E TRADE. Alternatively, you can call us on No Dividends or Entitlements Exchange traded options do not entitle investors to dividends or other entitlements paid by the issuer of the underlying securities, unless the investor exercises the option to become the holder of the underlying securities at or before the relevant date for dividend or entitlement purposes. Opening an option position The establishment of an exchange traded options contract is referred to as opening a position. Once the taker of an exchange traded option has an open position they have three alternatives: 1. The taker can exercise the option. 2. The taker can hold the option to expiry and allow it to lapse. 3. The taker can close out their position by writing (selling) an option in the same series as originally taken and instructing their broker to close out the earlier open position. The writer of an exchange traded option has two alternatives: 1. Let the option go to expiry and risk being exercised against (if it is not exercised against, it will expire without any further obligation or liability on the writer); or 2. Close out the option by taking (buying) the option in the same series as originally taken (provided it has not been exercised against). Closing out of option contracts An exchange traded option position may be closed out by placing an order equal and opposite in effect to your original order this effectively cancels out the open position. An investor might close out an option contract: when there is a risk of unwanted early exercise (unless an index option or LEPO, as they can only be exercised on expiry day) to take a profit to limit a loss. E TRADE will automatically treat a buy or sell order in a particular series as a close out against any opposite series held. Example If you are long 10 contracts in BHP48, and you place an order to sell 6 contracts in that same series, E TRADE will treat that sell order as a partial close out of your existing BHP48 long position, and if that order is executed, your long position in BHP48 will be 4 contracts. Closing out can be achieved without reference to the original party to the trade because of the process of novation. The Clearing House is able to substitute a new buyer as the contract party when an existing buyer sells to close their position. The process of novation is discussed in more detail below in the section entitled Trading and clearing options. Expiry Exchange traded options have a limited life span and every option within the same series, which has not already been exercised, will expire on the expiry day. The expiry day is a standard day set by the ASX. For exchange traded options, other than index options, the option expires on the Thursday preceding the last Friday in the month, as long as both the Thursday and Friday are business days. Therefore if the last day of the month is a Thursday the option will expire on the Thursday prior. For index options, expiry is usually the third Friday of the contract month. Expiry day information is available on the ASX website at trading_information/expiry_calendar.htm Exercise Option takers make the decision to exercise the option contract. This means that an equity option writer may be exercised against at any time prior to expiry, unless the contract is a LEPO or an Index Option), which can only be exercised at expiry. The Clearing House will randomly allocate a writer for every exercised taken position. This means that if the taker wants to exercise the options and either buy or sell (depending on whether it is a call or a put) at the predetermined price then ASX randomly allocates a writer of that option and allocates the exercise against them. The writer must then sell the shares at a predetermined price for a call or buy the shares at the predetermined price for a put. The taker of an option will generally only exercise for a profit and therefore the exercise may result in a loss to the writer of the option, depending on their initial costs. Once a writer has been allocated, the writer has lost the opportunity to close out their position and must effect the delivery or cash settlement obligations for the particular equity option contract. Automatic exercise Unless you or your authorised agent requests us to do otherwise by no later than 4.30pm on the date of expiry, E TRADE will automatically exercise your taken exchange traded option contract if your contract is one cent in the money or one point for indexes. For call options the option will be in the money where the exercise price is below the price of the underlying shares. For put options the option will be in the money where the exercise price is higher than the price of the underlying shares. All unexercised option contracts will expire on the expiry date.

7 Settlement Payment for, and the delivery of underlying securities, on exercise of an open exchange traded options contract occurs via the ASX s Clearing House Electronic Subregister System (CHESS) on T+3. E TRADE is obligated to make payment to the ASX within this timeframe. For cash settled index options, a cash settlement amount calculated having regard to the opening price index calculation on expiry day, is paid to exercising takers on the day following the expiry date. The level used for settling index options is determined by a special formula. If you intend investing in index options you should take the time to understand these arrangements. For more information on settlement of index options see the ASX Booklet Understanding Options Trading section on Trading index options. If you intend to trade LEPO s we recommend that you refer to the ASX Booklet Low Exercise Price Options. E TRADE requires that you settle at T+1 (that is within 24 hours from the time the trade occurred) for all cash positions which arise from premiums, interest, and other cash financial transactions. This requirement is reflected in the terms of our client agreement with you. You are required to pay the margin amounts we call from you within 24 hours of being advised of the margin amount by us. Please see the discussion on margins below. SIGNIFICANT BENEFITS OF EXCHANGE TRADED OPTIONS Exchange traded options have a number of advantages and include: Risk management where investors can hedge (protect) their share portfolio from a drop in value. Put options allow investors holding shares to hedge against a fall in the share price; Shareholders can earn income by writing call options over shares they already hold. As a writer of options, the investor will receive the premium amount up front. The risk is that the writer may be exercised against and be required to deliver their shares to the taker at the exercise price. By taking a call option, the purchase price for the underlying shares is locked in. This gives the call option holder time to decide whether or not to exercise the option and buy the shares. The holder has until the expiry date to make his/her decision. Likewise the taker of a put option has time to decide whether or not to sell the shares; Exchange traded options benefit from standardization and registration with a clearing and settlement facility which reduces counterparty default risk. This process provides the benefit that the client s position can be closed out without reference to the original counterparty and the client s risk to that counterparty is transferred to the Clearing House; Speculation where the flexibility of entering and exiting the market prior to expiry permits an investor to take a view on market movements and trade accordingly. In addition the variety of option combinations allows investors to develop strategies regardless of the direction of the market; Options do not require a rising market to make money, rather investors can profit from both rising and falling markets depending on the strategy they have employed. Strategies may be complex and strategies will have different levels of risk associated with each strategy; The initial outlay for an options contract is not as much as investing directly in the underlying shares. Trading in options can allow investors to benefit from a change in the price of the share without having to pay the full price of the share. An investor can therefore purchase an option (representing a larger number of underlying shares) for less outlay and still benefit from a price move in the underlying shares. The ability to make a higher return for a smaller initial outlay is called leverage. Investors however, need to understand that leverage can also produce increased risks (see below). Given the lower initial outlay attaching to options, investors can diversify their portfolios and gain a broad market exposure over a range of securities or the index itself. Example Exchange Traded Options Scenario 1 - Income You are the holder of Share A and you wish to supplement your dividend income. You decide to write a call option. The current market price for Share A is $8.72 You write a November Share A call option with an exercise price of $9.02. The premium payable to you for the option is $0.98. The total premium is payable to you is $980. The price of the Share A has steadily fallen and at expiry, Share A is trading at $8.47. The call option is not exercised but you have received $980 by way of premium received for writing the option. Scanario 2 - Speculation You believe that Share A will rise in value considerably in five months time. In June, Share A is trading at $9.58 and you believe that at the end of November, Share A will be trading at $ A November Share A call option with an exercise price of $9.47 costs $0.38. You decide to purchase 1 November Share A call option. Premium payable for the November Share A call option = $0.38 x 1000 = $380 In November, the price of Share A has risen to $ You exercise the call option and receive 1000 Share A shares for $9.47. You immediately sell the shares at the market price. Your profit = [$ $9.47] x $380 = $970 7

8 Scenario 3 -Hedging You own 1,000 Share A shares and you think the price will fall. Writing call options will offset some of the loss, but you would like to be able to lock in a sale price for your shares if the market does fall. You could take 1 Share A June $8.98 put option for $0.67 ($670). The price of Share A does fall to $7.97 prior to the expiry date and you decide to exercise your put option. In exercising the put option, you protected yourself and have reduced the impact of the fall in the share price of Share A by: Example LEPOs Leverage Date Buying 1,000 Share A shares Purchase price= $8.23 buying a lepo premium = $8,570 per contact or $8.57 per share [ ] * = $340 Scenario 4 - Leverage Buying call options allows you to profit from an increase in the price of the underlying shares. Suppose you believe Share A shares will rise in price over the next few months. You don t want to pay the full $5,570 to buy 1,000 shares so you decide to take a September $5.50 call for 40 cents ($400 plus fees and commissions). If you are correct and the price of AMP shares rises then the value of your option will also rise. You can then write an equivalent call option to close out at any time prior to the expiry day and take your profit. You will not have to buy the Share A shares if you don t want to. If the market doesn t move as expected, you can either close out the option and recoup some of your initial investment, or you can simply let the option expire worthless in September. When you take a call option, the most you can lose is the premium you have paid in the first place. SIGNIFICANT BENEFITS OF LEPOs When you open a LEPO contract you gain exposure to the full value of the underlying securities but actually pay only a fraction of the full premium of the LEPO up front. This potentially provides a greater return to the investor but also means LEPOs have a higher risk profile. 28 Oct 3 Nov 13 Nov Buy 1,000 Share A shares at $8.23, $8,230 Share A share price at $8.47 Share A share price at $8.61 Risk Margin (5% of 8,230) $ LEPO Price $8.88 Risk Margin (at 5%) = $ ($ $411.50) = $12 (pay) Mark to market margin = ($8,570 - $8,880) = $310 (return) Daily settlement = $298 (receive) LEPO Price $9.02 Risk Margin (at 5%) = $ ($ $423.50) = $7 (pay) Mark to market margin = ($8,880 - $9,020) = $140 (return) Daily settlement = $133 (receive) Selling a LEPO gives you exposure to a decline in the value of the underlying asset, enabling you to profit if the price of the asset falls. The sale of a LEPO can be compared to a short stock position, but the LEPO position can in many cases be established more easily and at a lower cost. Using a LEPO can also be a cost-effective alternative to borrowing to fund a purchase of shares. Credit margins from existing open positions may be used to reduce the initial margin payable. This can further reduce the cash outlay when opening a contract. 22 Nov Sell shares at $8.82 Total Profit $590 Sell LEPO at $9.23 Risk margin reversed = $ (return) Mark to market reversed = ($9,020 $8,570) = $450 (pay) LEPO Profit ($9,230 $8,570) = $660 (return) LEPOs are European style options, meaning they are only exercisable at expiry and you will not have to be concerned about the possibility of an early exercise. Daily settlement ($ ) = $ (return) Funding Cost = 7%* $8,230 = $39.50 No Funding Cost TOTAL PROFIT = $ TOTAL PROFIT = $660 8

9 SIGNIFICANT RISKS EXPLAINED The risk of loss in trading in exchange traded options can be substantial. It is important that you carefully consider whether trading exchange traded options is appropriate for you in light of your investment objectives and financial circumstances. You should only trade exchange traded options if you understand the nature of the products and the extent of your exposure to risks. The risks attached to investing in exchange traded options will vary in degree depending on the option traded. see the risks outlined below. This PDS does not cover every aspect of risk associated with exchange traded options. For further information concerning risks associated with exchange traded option trading you are referred to the ASX booklet Understanding Options Trading and in particular the section entitled Risks of option trading (the booklet can be found on the ASX website at Exchange traded options are not suitable for some retail investors, for example, investors who have a low risk tolerance should not enter into exchange traded option trades which have the potential for unlimited losses. In deciding whether or not you should trade exchange traded option contracts, you should be aware of the following matters relating to risk: (a) the high level of leverage that is obtainable in trading exchange traded options (due to the low level of initial capital outlay) can work against an investor as well as for the investor. Depending on the market movement, the use of leverage may lead to large losses as well as large gains. (b) Exchange traded options have a limited life span as their value erodes as the option reaches its expiry date. It is therefore important to ensure that the option selected meets the investors investment objectives. (c) Exchange traded options are subject to movements in the underlying market. Options may fall in price or become worthless at or before expiry. (d) The maximum loss in taking (buying) an exchange traded option is the amount of premium paid. If the option expires worthless, the taker will lose the total value paid for the option (the premium) plus transaction costs. (e) Whilst writers (sellers) of exchange traded options earn premium income, they may also incur unlimited losses if the market moves against the option position. The premium received by the writer is a fixed amount; however the writer may incur losses greater than that amount. For example, the writer of a call option has increased risk where the market rises and the writer does not own the underlying shares. If the option is exercised, the writer of the option is forced to buy the underlying shares at the current (higher) market price in order to deliver them to the taker at the exercise price. Similarly where the market falls, the writer of a put option that is exercised is forced to buy the underlying shares from the taker at a price well above the current market price. (f) Writers of options could sustain a total loss of margin funds deposited with their broker where the market moves against the option position. In addition, the writer may be obligated to pay additional margin funds (which may be substantial) to maintain the option position or upon settlement of the contract. Margining is discussed below. (g) Under certain conditions, it could become difficult or impossible to close out a position. This can happen for example where there is a significant change in price over a short time period. (h) The ASX and its Clearing House have discretionary powers in relation to the market. They have power to suspend the market operation, or lift market suspension in options while the underlying securities are in trading halt if the circumstances are appropriate, restrict exercise, terminate an option position or substitute another underlying security (or securities), impose position limits or exercise limits or terminate contracts - all to ensure fair and orderly markets are maintained as far as practicable. These actions can affect an investor s option positions. (i) The placing of risk minimisation orders may not always limit an investors losses to the amounts that are expected. Market conditions may make it impossible for a broker to execute the risk minimisation orders. Strategies using combinations such as spreads or straddles may be as risky as taking a simple long or short position. (j) Trades effected on the ASX may be subject to dispute. When a trade is subject to a dispute the ASX has powers, in accordance with its rules, to request that a broker amend or cancel a trade, which will in turn result in the contract with the client being amended or cancelled. (k) E TRADE has the ability to amend or cancel the trade as stated in our Terms and Conditions of Trading and any Confirmation / Contract Note issued. This could cause you to suffer loss or increase your loss. ; (l) Trades effected on the ASX are traded on an electronic trading platform and cleared through theclearing House. As with all such electronic platforms and systems, they are subject to failure or temporary disruption. If the system fails or is interrupted we will have difficulties in executing all or part of your order according to your instructions. An investor s ability to recover certain losses in these circumstances will be limited given the limits of liability imposed by the ASX and the Clearing House; SIGNIFICANT RISKS OF LEPOS EXPLAINED LEPOs are subject to all of the risk factors that affect exchange traded options. However, as LEPOs have a low exercise price, the full premium amount will be closer to the full value of the underlying instrument than a standard exchange traded option. Although the buyer of a LEPO may only be required to outlay a relatively small amount of money when the LEPO 9

10 is entered into, at expiry, if the buyer of a LEPO does not exercise the LEPO, they will lose an amount approximately equal to the then current premium of the LEPO. LEPOs are leveraged investments and potential profits and losses can be greater than the money initially outlaid. Both buyers and sellers of LEPOs are required to pay margins to the Clearing House. For further information relating to risks associated with LEPO s trading, you are referred to the ASX Booklet Low Exercise Price Options, which can be obtained via the ASX website at COSTS AND AMOUNTS PAYABLE ASSOCIATED WITH TRADING EXCHANGE TRADED OPTIONS Costs Part 2 of this PDS contains information on the commission, brokerage and exchange fees attaching to exchange traded options. Amounts Payable Margins The Clearing House calculates margin amounts using a system known as TIMS (Theoretical Intermarket Margining System). Writers of options will be obligated to pay margin. Margins are generally a feature of all exchange traded derivative products and are designed to protect the financial security of the market. A margin is the amount calculated by the Clearing House as necessary to cover the risk of financial loss on an options contract due to an adverse market movement. This means that if the price of your options moves against you, you will be asked to pay a margin which represents that adverse movement. Total margin for exchange traded options is made up of two components: Premium margin this is market value of the particular position at the close of business each day. Risk margin this is the potential change in the price of the option contract assuming the maximum probable inter-day price move in the price of the underlying security or index. In times of extreme volatility an intra day margin call may be made by the Clearing House and as a consequence, we may request that you pay this on the same day. We may call more margin from you, compared to the amount that it is obligated to be paid to the clearing house we do this as a risk management tool. Clearing House margin obligations may be met by paying cash or by providing certain types of eligible collateral (eg. shares and bank guarantees). Clearing House applies a haircut in relation to the value of such collateral as a risk management tool, eg. Clearing House generally values collateral held by it at 70% of its full value. This means that if the shares used by you as collateral have a market value of $10,000 only 7,000 will be counted as collateral cover for your margin calls. Collateral can be used to cover risk margins for LEPOs, but it cannot be used to cover mark to market margins, which must be paid in cash. Margin must be paid by you within 24 hours of you being advised of the margin call by us. The margining process used by Clearing House is explained in detail in the ASX booklet Understanding Margin Obligations which is available on the ASX website at Any interest levied on late settlement and margin payments is due and receivable at the time the amount is levied and certainly within 1 business day of a demand being made by E TRADE. OTHER SIGNIFICANT CHARACTERISTICS OF EXCHANGE TRADED OPTION CONTRACTS Trading and clearing options Exchange traded options are traded on the ASX s trading platform and cleared through the Clearing House. Participants of ASX must comply with the operating rules of the ASX. Participants who clear option contracts must comply with the operating rules of the Clearing House. E TRADE is licensed to execute exchange traded option contracts on the ASX s trading platform for such products, and to clear them through the Clearing House. The Clearing House stands between the buying and selling brokers (the ASX participants) and guarantees the performance to each of them. This process is known as novation. Importantly the Clearing House does not have an obligation to you, the underlying client. The rules of the ASX s equities clearing house govern arrangements once a deliverable exchange traded option has been exercised. Client Trust Accounts and collateral In order for us to trade an exchange traded option contract for you, we require you to provide us with money or property to enable us to manage the risks associated with our dealings for you in exchange traded options. Client money and property paid or given by you in connection with our advising or dealing in exchange traded options must be held by us in trust in accordance with the Corporations Act and the ASX rules. Funds required for settlement with the market will be withdrawn from the E TRADE Cash Account established on your behalf, which includes your name as part of the account title. Money will be held on trust for you in a trust account, however, this does not apply to money paid to reimburse us for payments we have had to make to the Clearing House (generally margin calls) in respect of dealings for you. The Corporations Act provides that money held in the trust account can be used for specific purposes such as meeting margin obligations, guaranteeing, securing, transferring, 10

11 adjusting or settling dealings in derivatives. CHESS securities (held by you) may be lodged in your name with the Clearing House as collateral for margin obligations relating to option trades. When CHESS securities are lodged with the Clearing House, the securities are held by the Clearing House as a third party security. The lodged securities cannot be used by us in relation to our dealings or for our other clients in relation to their dealings unless authorised by you as third party collateral. Shares in a client s superannuation fund cannot be used as third party collateral for any other account. National Guarantee Fund The National Guarantee Fund (NGF) provides investors with protection in the following circumstances: 1. If a stock option is exercised, the NGF guarantees completion of the resulting trades in certain circumstances; and 2. If you have entrusted property to E TRADE in the course of dealing in options, and E TRADE later becomes insolvent, you may claim on the NGF, in accordance with the rules governing the operation of the NGF, for any property which has not been returned to you or has not otherwise been dealt with in accordance with [#1] s obligations to you. There are limits on claims to the NGF for property entrusted. For more information on the possible protections offered by the NGF see DISPUTE RESOLUTION SYSTEM You may advise of any complaint or dissatisfaction with the service or advice provided to you by E TRADE. The following dispute resolution procedure is in place to ensure that your enquiries and complaints are handled efficiently. 1. Contact E TRADE or E TRADE s Trading Manager Derivatives, and advise us of your complaint. A representative of E TRADE will attempt to resolve your complaint and will notify you of any proposed resolution. 2. If your complaint is not resolved to your satisfaction, please send your complaint in writing to: Compliance Manager ETRADE Australia Securities Ltd Level 7, 10 Bridge Street, Sydney NSW If you have not received a satisfactory response or 45 days have elapsed, you may refer the matter to the Financial Industry Complaint Service Ltd (FICS) of which E TRADE is a member (membership category and ID number: F-473). FICS can be contacted as below: Financial Industry Complaints Service Ltd. PO Box 579 Collins Street West Melbourne Vic 8007 Telephone: Facsimile: (03) fics@fics.asn.au Internet: If you require further information on how complaints are handled by E TRADE, please visit our website on or refer to our Financial Services Guide. SIGNIFICANT TAXATION IMPLICATIONS The information below is based on existing tax law and established interpretations as at the date of this Product Disclosure Statement. The taxation information provided below is intended as a brief guide only and does not cover every aspect of taxation related with the use of exchange traded options and low exercise price options ( LEPOs ). The information applies to Australian resident investors only. It is important to note that your tax position when trading exchange traded options and LEPOs will depend on your individual circumstances, in particular whether you are trading on revenue or capital account (refer below for further discussion). The taxation of options can be complex and may change over time. Accordingly, you are recommended to seek professional tax advice before entering in to or disposing of an exchange traded option or LEPO. Implications for Australian Resident Investors Revenue Account Writer of the Option Where a writer of an option writes an option in the ordinary course of business or the option has been written over an underlying revenue asset, the option will be treated as being on revenue account. The premium received by the writer of the option will be assessable on a due and receivable basis. Where any premium is credited to the writer s Clearing House account the amount will still be assessable on this basis. Any subsequent margin calls are not be deductible when they are deposited by the writer into their Clearing House account. These margins will merely reduce any net position of the writer upon the close-out, settlement or exercise of the option by the taker. Where interest is received by the writer on the margins held in their Clearing House account, this is required to be included in the writer s assessable income. 11